Wednesday, October 14, 2009

Here's a Bloomberg screen showing the yield on 3-mo. T-bills since the beginning of last year. The world's favorite safe asset is now yielding close to ZERO (actually, 0.06%), and that yield has been declining for most of the year, despite the double-digit gains recorded by domestic and global stock markets, corporate bonds, industrial commodities, gold, and crude oil, and despite the strong fundamental backdrop of sharply lower swap spreads and implied volatility, and increased liquidity. With the Dow reaching 10,000 today, it is up 53% from its closing low last March, and the S&P 500 is up 61%.

It only makes sense to hold zero-interest cash if the prices of alternative investments continue to decline. If the economy doesn't continue to deteriorate significantly, then cash will prove to be a major embarrassment."

With the underlying fundamentals (e.g., swap spreads, agency spreads, implied volatility, liquidity) improving, the economy is not likely, in my view, to deteriorate enough to keep the prices of other assets declining. Thus, as time passes, investors will be compelled to trade in their cash (or increase their borrowings, since borrowing costs will be extraordinarily low) in exchange for riskier assets. And that in turn will set off a virtuous cycle to the upside which could be rather spectacular.

It took a few months for the rally to get started, and we had to suffer through the awful February-early March collapse, but we're clearly witnessing one of the most spectacular rallies in Wall Street history.

The Fed helped get this rally going by ensuring that there was no shortage of money (another favorite theme of mine). Even though people have been terrified of depression and deflation, and even though people continue to be awfully worried about a double-dip recession, a collapse of the commercial real estate market, another wave of residential defaults, the deleveraging of the household sector, and/or a potential Fed tightening, there remains the fact that the Fed is keeping short-term interest rate extraordinarily low. To willingly hold cash that yields zero, you must be convinced that there is death and destruction awaiting at every turn. The market is climbing terrifying walls of worry, yet on the margin people are slowly being forced to reduce their money balances and increase their exposure to risk, and consumers are spending some of the cash they have hoarded, and it all adds up to a virtuous cycle that is giving us a V-shaped recovery. As long as the economy fails to deliver death and destruction, the market finds itself compelled to keep this virtuous cycle going.

The Fed should have started tightening awhile ago, but they are throwing caution to the wind in order to ensure a recovery. What the Fed wants, it can surely get. It may get more than it wants, in the form of asset price bubbles and higher inflation, but that remains to be seen. In the meantime, I don't see any signs that equities are overpriced (the Dow has only just returned to levels it first saw over 10 years ago) or that the market is overly confident (credit spreads are still very wide and implied volatility is still unusually high).

Here's how I see it. Speaking in rough terms, over the past 10 years: nominal GDP has risen 58%, real GDP has risen 22%, and corporate profits (according to NIPA) are up 55%. Yet stock prices are unchanged. With hindsight, equities were overvalued in 1999 and 2000. But at the very least they are an order of magnitude less overvalued today, if not downright cheap.

If you accept the proposition that the economy is likely to grow 3-4% for the foreseeable future, which is a pessimistic forecast given how deep the recent recession was, then you should have no trouble seeing that corporate profits and nominal GDP will be rising meaningfully. I find it very difficult to believe that stocks have serious downside risk in this environment.

At the risk of sounding like a lawyer, what does "the forseeable future" mean? Potential [real] growth was perhaps 2.75-3% pre-crisis, so working on the assumption it's unchanged, you're assuming growth at or above trend.

I think it's difficult to see more than a year or two of the future. The economy's trend growth used to be about 3% per year, but that may have slipped to 2.5% in recent years. Projecting growth of 3-4% for the next year or two would still leave the economy significantly below a 2.5% trend growth path, because the recent recession put us way below the trend path.

Here's the math: figure the economy is about 7% below potential right now, and that potential will grow 2.5% a year. So in two years potential will be 5% higher than it is today. If the economy grows 3.5% for two years, it would still be 5% below potential. That's a slow recovery by historical standards.

Public: one answer to the question "why so much wealth yet no increase in prices" is that the market knows that the heavy hand of government is going to be very depressing, that tax burdens are going to rise, so valuations are depressed.

I do not think it is as much a function of the heavy hand of government as much as it is the intrusion of government everywhere, whether it be through higher taxes, growing liabilities, or cheap money and egregious incentives.

All have an interconnectedness to the government and this has only magnified, not diminished.

What about old-fashioned P/E ratios. The S&P is around 1050. If a P/E of 14 is fair price, we'd need earnings to be around $75. Obviously earnings are depressed at the moment, but they're still only around $40 (last quarter they were $10, so $40 annualized).

Earnings would need to almost double over the next year or two just to get to fair price, much less cheap. Is that realistic given the chances of a sluggish recovery?

We've applied the Costco-shopping-cart (COC) theory of economics over the last few months.

Applying COC is easy -- sit down and eat a slice of Costco pizza and examine the contents of carts leaving the checkstands. Six months ago they were filled with nothing but essentials; over the last month we've seen a huge increase in non-essentials in the carts.